Chap 006 - 2e by Wild and Shaw

Chapter 6Variable Costing and Performance Reporting

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Conceptual Learning ObjectivesC1: Distinguish between absorption costing and variable costing.C2: Describe how absorption costing can result in over-production.C3: Explain the role of variable costing in pricing special orders.

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Analytical Learning ObjectivesA1: Analyze income reporting for both absorption and variable costing.A2: Compute and interpret breakeven volume in units.

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Procedural Learning ObjectivesP1: Compute unit cost under both absorption and variable costing. P2: Prepare an income statement using absorption costing and using variable costing. P3: Prepare a contribution margin report.P4: Convert income under variable costing to the absorption cost basis.

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Absorption Costing & Variable Costing Absorption costing (also called full costing), assumes that products absorb all costs incurred to produce them.While widely used for financial reporting (GAAP), this costing method can result in misleading product cost information for business decisions. C1

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Absorption Costing & Variable CostingUnder variable costing, only costs that change in total with changes in production level are included in product costs.C1

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Distinguishing Between Absorption Costing and Variable Costing: Absorption CostingAbsorption CostingProduct CostC1

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Distinguishing Between Absorption Costing and Variable Costing: Variable CostingVariable CostingProduct CostPeriod Cost C1

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Difference Between Absorption Costing and Variable Costing: Computing Unit Cost

P1

Sheet1

Exhibit 6.1 Summary Cost Data

Direct materials cost.$4 per unit

Direct labor cost.$8 per unit

Overhead cost

Variable overhead cost..$180,000

Fixed overhead cost..600,000

Total overhead cost..$780,000

Expected units produced..60,000 units

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Difference Between Absorption Costing and Variable Costing: Computing Unit Cost

P1

Sheet1

Exhibit 6.2 Unit Cost Computation

Absorption CostingVariableCosting

Direct labor cost per unit...$8$8

Direct materials cost per unit.44

Overhead cost

Variable overhead cost per unit..33

Fixed overhead cost per unit...10-

Total product cost per unit.$25$15

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Analysis of Income Reporting for Both Absorption and Variable CostingA1

Sheet1

Exhibit 6.3 Summary Cost Information for 2007-2009

Production CostsNon-Production Costs

Direct materials cost $4 per unitVariable selling and administrative expenses $2 per unit

Direct labor cost $8 per unitFixed selling and administrative expenses $200,000 per year

Variable overhead cost $3 per unit

Fixed overhead cost $600,000 per year

Sheet1

Units ProducedUnits SoldUnits in Ending Inventory

200760,00060,0000

200860,00040,00020,000

200960,00080,0000

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Analysis of Income Reporting for Absorption Costing: Units Produced Equal Units Sold

A1P2

Sheet1

Exhibit 6.4 Income for 2007-----Quantity Produced Equals Quantity Sold

IceAge Company

Income Statement (Absorption Costing)

For Year Ended December 31, 2007

Sales (60,000 x $40)..$2,400,000

Cost of goods sold (60,000 x $25*)1,500,000

Gross margin900,000

Selling and administrative expenses [$200,000 + (60,000 x $2)]320,000

Net income..$580,000

*Units produced equal 60,000; units sold equal 60,000.

See Exhibit 6.2 for unit cost computation under absorption and variable costing.

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Analysis of Income Reporting for Variable Costing: Units Produced Equal Units Sold

A1P2

Sheet1


IceAge Company

Income Statement (Variable Costing)


Sales (60,000 x $40)$2,400,000

Variable expenses

Variable production costs

(60,000 x $15*) $900,000

Variable selling and administrative

expenses (60,000 x $2) 120,0001,020,000

Contribution margin1,380,000

Fixed expenses

Fixed overhead 600,000

Fixed selling and

administrative expense $200,000$800,000

Net income$580,000

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Analysis of Income Reporting for Variable Costing: Units Produced Equal Units Sold

A1P2

Sheet1


IceAge Company



Sales (60,000 x $40)$2,400,000

Variable expenses


(60,000 x $15*) $900,000


expenses (60,000 x $2) 120,0001,020,000


Fixed expenses


Fixed selling and

administrative expense $200,000$800,000

Net income$580,000

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Analysis of Income Reporting for Both Absorption and Variable Costing: Units Produced Equal Units Sold

A1

Sheet1

Exhibit 6.4A Production Cost Assignment for 2007

Cost of Goods SoldEnding InventoryPeriod Cost2,007

(Expense)(Asset)(Expense)Expense

Absorption Costing

Direct materials60,000 x $4 $ 240,0000 x $4 $ 0$240,000

Direct labor60,000 x $8 480,0000 x $8 0480,000

Variable overhead60,000 x $3 180,0000 x $3 0180,000

Fixed overhead60,000 x $10 600,0000 x $10 0600,000

Total costs$1,500,000$0$1,500,000

Variable Costing

Direct materials60,000 x $4 $ 240,0000 x $4 $ 0240,000

Direct labor60,000 x $8 240,0000 x $8 0480,000


Fixed overhead$600,000600,000

Total costs$900,000$0$600,000$1,500,000

Cost difference0

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Analysis of Income Reporting for Absorption Costing: Units Produced Exceed Units Sold

A1P2

Sheet1

Exhibit 6.5 Income for 2008----Quantity Produced Exceeds Quantity Sold

IceAge Company



Sales (40,000 x $40)$1,600,000

Cost of goods sold (40,000x$25*)1,000,000

Gross margin600,000


Net income$320,000



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Analysis of Income Reporting for Absorption Costing: Units Produced Exceed Units Sold

A1P2

Sheet1


IceAge Company



Sales (40,000 x $40)$1,600,000


Gross margin600,000


Net income$320,000



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Analysis of Income Reporting for Variable Costing: Units Produced Exceed Units Sold

A1P2

Sheet1


IceAge Company



Sales (40,000 x $40)$1,600,000

Variable expenses


(40,000 x $15*) $600,000


expenses (40,000 x $2) 80,000680,000

Contribution margin920,000

Fixed expenses


Fixed selling and

administrative expense 200,000800,000

Net income$120,000

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A1P2

Sheet1


IceAge Company



Sales (40,000 x $40)$1,600,000

Variable expenses


(40,000 x $15*) $600,000


expenses (40,000 x $2) 80,000680,000


Fixed expenses


Fixed selling and


Net income$120,000

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A1P2

Sheet1

Exhibit 6.5 Income for 2008 ---Quantity Produced Exceeds Quantity Sold

IceAge Company



Sales (40,000 x $40)$1,600,000

Variable expenses


(40,000 x $15*) $600,000


expenses (40,000 x $2) 80,000680,000


Fixed expenses


Fixed selling and


Net income$120,000

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Analysis of Income Reporting for Both Absorption and Variable Costing: Units Produced Exceed Units Sold

A1

Sheet1


Cost of Goods SoldEnding InventoryPeriod Cost2008


Absorption Costing

Direct materials40,000 x $4 $ 160,00020,000 x $4 $ 80,000$160,000

Direct labor40,000 x $8 320,00020,000 x $8 160,000320,000

Variable overhead40,000 x $3 120,00020,000 x $3 60,000120,000

Fixed overhead40,000 x $10 400,00020,000 x $10 200,000400,000

Total costs$1,000,000$500,000$1,000,000

Variable Costing

Direct materials40,000 x $4 $ 160,00020,000 x $4 $ 80,000$160,000

Direct labor40,000 x $8 320,00020,000 x $8 160,000320,000

Variable overhead40,000 x $3 120,00020,000 x $3 60,000120,000

Fixed overhead_______________$600,000600,000

Total costs$600,000$300,000$600,000$1,200,000

Cost difference($200,000)

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Analysis of Income Reporting for Absorption Costing: Units Produced Are Less Than Units SoldA1P2

Sheet1

Exhibit 6.6 Income for 2009Quantity Produced is Less Than Quantity Sold

IceAge Company



Sales (80,000 x $40)$3,200,000


Gross margin1,200,000


Net income$840,000



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Analysis of Income Reporting for Variable Costing: Units Produced Are Less Than Units SoldA1P2

Sheet1

Exhibit 6.6 Continued

IceAge Company



Sales (80,000 x $40)$3,200,000

Variable expenses

Variable production costs (80,000 x $15*) $1,200,000

Variable selling and administrative expenses ($80,000 x $2) 160,0001,360,000


Fixed expenses


Fixed selling and


Net income$1,040,000

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Analysis of Income Reporting for Both Absorption and Variable Costing: Units Produced Are Less Than Units Sold

A1

Sheet1


Cost of Good SoldEnding InventoryPeriod Cost2009


Absorption Costing


Direct labor80,000 x $8 640,0000 x $8 0640,000


Fixed overhead80,000 x $10 800,0000 x $10 0800,000

Total costs$2,000,000$0$2,000,000

Variable Costing


Direct labor80,000 x $8 640,0000 x $8 0640,000


Fixed overhead___________$600,000600,000

Total costs$1,200,000$0$600,000$1,800,000

Cost difference$200,000

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Income Reporting Summarized

A1

Sheet1

Exhibit 6.7 Summary of Income Statements

Units ProducedIncome for Absorption CostingIncome for Variable Costing

and SoldDifference

2007Units produced: 60,000$580,000$580,000$0

Units sold: 60,000

2008Units produced: 60,000320,000120,000200,000

Units sold: 40,000

2009Units produced: 60,000840,0001,040,000-200,000

Units sold: 80,000

TotalsUnits produced: 180,000$1,740,000$1,740,000$0

Units sold: 180,000

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Planning ProductionC2Greater risk of obsolescenceCustomer dissatisfaction

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Planning Production

C2

Sheet1

Exhibit 6.8 Unit Cost Under Absorption Costing

When 60,000 Units are ProducedWhen 100,000 Units are Produced

Direct materials cost$4 per unitDirect materials$4 per unit

Direct labor cost8 per unitDirect labor8 per unit

Variable overhead3 per unitVariable overhead3 per unit

Total variable cost15 per unitTotal variable cost15 per unit

Fixed overhead ($600,000/60,000 units)10 per unitFixed overhead ($600,000/100,000 units)6 per unit

Total production cost$25 per unitTotal production cost$21 per unit

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Planning Production: Income Under Absorption Costing for Different Production Levels C2Exhibit 6.9

Sheet1

IceAge CompanyIceAge Company

Income Statement (Absorption Costing)Income Statement (Absorption Costing)

For Year Ended December 31, 2007For Year Ended December 31, 2007

[60,000 Units Produced; 60,000 Units Sold][100,000 Units Produced; 60,000 Units Sold]

Sales (60,000 x $40)$2,400,000Sales (60,000 x $40)$2,400,000

Cost of goods sold (60,000 x $25*)1,500,000Cost of goods sold (60,000 x $21**)1,260,000

Gross margin900,000Gross margin1,140,000

Selling and administrative expensesSelling and administrative expenses

Variable (60,000 x $2) $120,000Variable (60,000 x $2) $120,000

Fixed 200,000320,000Fixed 200,000320,000

Net income$580,000Net income$820,000

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Planning Production: Income Under Absorption Costing for Different Production LevelsC2Exhibit 6.10

Sheet1

IceAge CompanyIceAge Company

Income Statement (Variable Costing)Income Statement (Variable Costing)

For Year Ended December 31, 2007For Year Ended December 31, 2007

[60,000 Units Produced; 60,000 Units Sold][100,000 Units Produced; 60,000 Units Sold]

Sales (60,000 x $40)$2,400,000Sales (60,000 x $40)$2,400,000

Variable expensesVariable expenses

Variable production costsVariable production costs

(60,000 x $15) $900,000(60,000 x $15) $900,000

Variable selling and administrativeVariable selling and administrative

expenses (60,000 x $2) 120,0001,020,000expenses (60,000 x $2) 120,0001,020,000

Contribution margin1,380,000Contribution margin1,380,000

Fixed expensesFixed expenses

Fixed overhead 600,000Fixed overhead 600,000

Fixed selling andFixed selling and

administrative expense 200,000800,000administrative expense 200,000800,000

Net income$580,000Net income$580,000

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Planning Production: Income Under Absorption Costing for Different Production LevelsC2Why is income under absorption costing affected by the production level when that for variable costing is not?The answer lies in the differenttreatment of fixed overheadcosts for the two method.

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Setting PricesOver the Long Run:Price must be high enough to cover all costs, including variable costs and fixed costs, and still provide an acceptable return to owners C3

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Setting PricesOver the Short Run:Fixed production costs such as the cost to maintain plant capacity do not change with changes in production levels. With excess capacity, increases in production level would increase variable production costs, but not fixed costs. While managers try to maintain the long-run price on existing orders, which covers all production costs, managers should accept special orders provided the special order price exceeds variable cost.

C3

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Setting PricesC3

Sheet1

Exhibit 6.11 Computing Incremental Income for a Special Order

Rejecting Special OrderAccepting Special Order

Incremental sales $ 0Incremental sales (1,000 x $22) $22,000

Incremental costs 0Incremental costs

Variable production cost (1,000 x $15) 15,000

____Variable selling expense (1,000 x $2) 2,000

Incremental income $ 0Incremental income $ 5,000

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Contribution Margin ReportP3Contribution margin is the excess of sales over total variable expensesContribution margin contributes to covering fixed costs and earning income

Sheet1

Precision Tech

Contribution Margin Report

For the year ended December 31, 2009

Sales$18,000

Variable Expenses

Variable production costs$3,600

Variable selling expenses6,80010,400

Contribution margin$7,600

Sheet2

Sheet3

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Contribution Margin ReportP3The Contribution Margin Ratio is contribution margin divided by sales

Sheet1

Precision Tech


For the year ended December 31, 2007%

of sales

Sales$18,000100.0%

Variable Expenses

Variable production costs$3,600

Variable selling expenses6,80010,40057.8%

Contribution margin$7,60042.2%

Sheet2

Sheet3

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Limitations of Reports Using Variable Costing

P3Absorption costing is almost exclusively used for external reporting (GAAP). For income tax purposes, absorption costing is the only acceptable basis for filings with the Internal Revenue Service (IRS) under the Tax Reform Act of 1986.

Absorption costing is the only acceptable basis for both external reporting and tax reporting.

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Converting Reports Under Variable Costing to Absorption Costing

P4

Sheet1

Exhibit 6.15 Converting Variable Costing Income to Absorption Costing Income

200720082009

Variable costing income$580,000$120,000$1,040,000

Add: Fixed overhead cost deferred in ending inventory (20,000 $10)0200,0000

Less: Fixed overhead cost recognized from beginning inventory (20,000 $10)00-200,000

Absorption costing income$580,000$320,000$840,000

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Calculating Break-EvenWe can use the data in the following contribution margin format for IceAge to help us determine break-even point.A2

Sheet1

IceAge Company


For the year ended December 31, 2009Per

Unit

Sales$2,400$40

Variable Expenses

Variable production costs$900

Variable selling expenses1201,02017

Contribution margin$1,380$23

Fixed expenses800

Net income$580

Sheet2

Sheet3

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Calculating Break-EvenBreak-Even Volume in Units = Total Fixed Costs Contribution Margin per UnitWhere:Contribution margin per unit = Sales price per unit Variable cost per unit

A2

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Calculating Break-EvenA2Precision Techs Break-Even Volume in UnitsTotal fixed costsCM per unit=$800,000$23 per unit=34,783 units

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End of Chapter 6

In presentations for each chapter in this text, we will provide you with sound to go along with the material on your screen. There will be sound on every slide you view. Please make sure your computer speakers are setup properly when viewing the material. Good luck and we hope you enjoy this new format.

This chapter describes managerial accounting reports that reflect variable costing. It also compares reports prepared under variable costing with those prepared under absorption costing, and it explains how variable costing can improve business decisions..In this chapter, you will learn the following conceptual objectives:C1: Distinguish between absorption costing and variable costing.C2: Describe how absorption costing can result in over-production.C3: Explain the role of variable costing in pricing special orders.

In this chapter, you will learn the following analytical objectives:A1: Analyze income reporting for both absorption and variable costing.A2: Compute and interpret breakeven volume in units.

In this chapter, you will learn the following procedural objectives:P1: Compute unit cost under both absorption and variable costing. P2: Prepare an income statement using absorption costing and using variable costing. P3: Prepare a contribution margin report.P4: Convert income under variable costing to the absorption cost basis.

Absorption Costing (also called full costing), assumes that products absorb all costs incurred to produce them. While widely used for financial reporting (GAAP), this costing method can result in misleading product cost information for business decisions.

Under variable costing, only costs that change in total with changes in production level are included in product costs. Those consist of direct materials, direct labor, and variable overhead.

Product costs generally consists of direct materials, direct labor, and overhead. Costs of both direct materials and direct labor usually are easily traced to specific products. Overhead costs, however, must be allocated to products because they cannot be traced to product units. Under absorption costing, all overhead costs, both fixed and variable, are allocated to products as the following diagram shows.

Under variable costing, the costs of direct materials and direct labor are traced to products, and only variable overhead costs (not fixed overhead) are allocated to products. Fixed overhead costs are treated as period costs and are reported as expense in the period when incurredLets look at Ice Age, a skate manufacturer, to help us to understand the difference between absorption and variable costing.

Exhibit 6.2 shows the product unit cost computations for both absorption and variable costing. For absorption costing, the product unit cost is $25, which consists of $8 in direct labor, $4 in direct materials, $3 in variable overhead ($180,000/60,000 units), and $10 in fixed overhead ($600,000/60,000 units).For variable costing, the product unit cost is $15, which consists of $4 in direct materials, $8 in direct labor, and $3 in variable overhead. Fixed overhead costs of $600,000 are treated as a period cost and are recorded as expense in the period incurred. The difference between the two costing methods is the exclusion of fixed overhead from product costs for variable costing.Now lets look at how variable and absorption costing determine income. Assume that Ice Ages variable costs per unit are constant and that its annual fixed costs remain unchanged during the three-year period 2007 through 2009. Its sales price was a constant $40 per unit over this time period.We see that the units produced equal those sold for 2005, but exceed those sold for 2006, and are less than those sold for 2007.

Exhibit 6.4 is split and is shown on two slides. This slide show the absorption costing income statement, and expenses are grouped according to function.

This slide shows the variable costing income statement. This format is referred to as the contribution margin income statement with expenses grouped according to cost behavior. We can see that when quantity produced equals quantity sold, the next income amounts are identical.Exhibit 6.4A reorganizes the information from Exhibit 6.4 to show the assignment of costs to different expenses and assets under both absorption costing and variable costing. When quantity produced equals quantity sold there is no difference in total costs assigned. Yet, there is a difference in what categories receive those costs. Absorption costing assigns $1,500,000 to cost of goods sold compared to $900,000 for variable costing. The $600,000 of fixed overhead difference is a period cost for variable costing.

What happens if Ice Age produces more units than it sells? Lets look at 2008, when Ice Age produced 60,000 units but only sold 40,000 units?

This slide shows the absorption costing income statement for 2008. In 2008, 60,000 units were produced, which is the same as in 2007. However, only 40,000 units were sold. There will be 20,000 units in ending inventory.This slide shows the variable costing income statement for 2008.Under variable costing income is $120,000, which is $200,000 less than under absorption costing. The cause of this $200,000 difference rests with the treatment of fixed overhead under the two costing methods.

Under variable costing, the entire $600,000 fixed overhead cost is treated as an expense in computing 2008 income. Under absorption costing, the fixed overhead cost is allocated to each unit of product at the rate of $10 per unit (see Exhibit 6.2). When production exceeds sales by 20,000 units (60,000 versus 40,000), the $200,000 ($10 x 20,000 units) of fixed overhead cost allocated to these 20,000 units is carried as part of the cost of ending inventory (see Exhibit 6.5A). This means that $200,000 of fixed overhead cost incurred in 2008 is not expensed until future periods when it is reported in cost of goods sold as those products are sold. Consequently, income for 2008 under absorption costing is $200,000 higher than income under variable costing.

Exhibit 6.5A reorganizes the information from Exhibit 6.5 to show the assignment of costs to different expenses and assets under both absorption costing and variable costing. When quantity produced exceeds quantity sold there is a difference in total costs assigned. As a result, income under absorption costing is greater than under variable costing because of the greater fixed overhead cost allocated to ending inventory (asset) under absorption costing. Those cost differences extend to cost of goods sold, ending inventory, and period costs. By now you should be able to predict what will happen if units produced is less than units sold. lets look at Ice Ages 2009 income statements where the units produced are less than the units sold.

IceAges income reported for 2009 under variable cost is $200,000 more than that under absorption costing. The income statements reveal that income is $840,000 under absorption costing, but it is $1,040,000 under variable costing.The cause of this $200,000 difference lies with the treatment of fixed overhead. Beginning inventory in 2009 under absorption costing included $200,000 of fixed overhead cost incurred in 2008, but is assigned to cost of goods sold in 2009 under absorption costing.

Exhibit 6.6A reorganizes the information from Exhibit 6.6 to show the assignment of costs to different expenses and assets under both absorption costing and variable costing. When quantity produced is less than quantity sold there is a difference in total costs assigned.Specifically, ending inventory in 2009 under absorption costing was $500,000 (20,000 units x $25) whereas it was only $300,000 (20,000 units x $15) under variable costing (See Exhibit 6.5A). Consequently, when that inventory is sold in 2009, the 2009 income under absorption costing is $200,000 less than the income under variable costing. That inventory cost difference flows through cost of goods sold and then to income.

Lets look at a summary of Ice Ages income over the last three years under both absorption and variable costing. Income reported under both variable costing and absorption costing for the period 2007 through 2009 for Ice Age is summarized in Exhibit 6.7. We see that the differences in income are due to timing as total income is $1,740,000 for this time period for both methods. Further, income under absorption costing and that under variable costing will be different whenever the quantity produced and the quantity sold are different. Specifically, income under absorption costing is higher when more units are produced relative to sales, and is lower when fewer units are produced than are sold. Our illustration using IceAge had the total number of units produced over 2007-2009 exactly equal to the number of units sold over that period. This meant that the difference between absorption costing income and variable costing income for the total three-year period is zero. In reality, it is unusual for production and sales quantities to exactly equal each other over such a short period of time. This means that we normally continue to see differences in income for these two methods extending over several years.Now lets examine how absorption costing can lead to poor production and pricing decisions and how variable costing can help us make better decisions. Production planning is an important managerial function. Producing too much leads to excess inventory, which in turn leads to higher storage and financing costs, and to greater risk of product obsolescence. On the other hand, producing too little can lead to lost sales and customer dissatisfaction. Production levels should be based on reliable sales forecasts. However over-production and inventory build-up can occur because of how managers are evaluated and rewarded. For instance, many companies link manager bonuses to income computed under absorption costing because this is how income is reported to shareholders (per GAAP).

What would happen if IceAges manager decided to produce 100,000 units instead of 60,000? The 40,000 extra units would be stored in inventory. What would the income look like? The left side of Exhibit 6.8 shows the unit cost when 60,000 units are produced (same as Exhibit 6.2). The right side shows unit costs when 100,000 units are produced. The exhibit is prepared under absorption costing for 2005. Total production cost per unit is $4 less when 100,000 units are produced. Specifically, cost per unit is $21 when 100,000 units are produced versus $25 per unit at 60,000 units. The reason for this difference is because the company is spreading the $600,000 fixed overhead cost over more units when 100,000 units are produced than when 60,000 are produced.The difference in cost per unit carries over to performance reporting. Exhibit 6.9 presents the income statement under absorption costing for the two alternative production levels.Common sense suggests that because the companys variable cost per unit, total fixed costs, and sales are identical in both cases, merely producing more units and creating excess ending inventory should not increase income. Yet, as we see in Exhibit 6.9, income under absorption costing is 41%* greater if management produces 40,000 more units than necessary and builds up ending inventory. The reason is that $240,000 of fixed overhead (40,000 units x $6) is assigned to ending inventory instead of being expensed in 2005. This shows that a manager can report increased income merely by producing more, and disregarding whether the excess units can be sold or not.

* The 41% income increase is computed as: $820,000-$580,000 = 0.41 $580,000

Manager bonuses are tied to income computed under absorption costing for many companies. Accordingly, these managers may be enticed to increase production that increases income and their bonuses. This incentive problem encourages inventory build-up, which leads to increased costs in storage, financing, and obsolescence. If the excess inventory is never sold, it will be disposed of at a loss.Exhibit 6.10 shows that managers cannot increase income by merely increasing production without increasing salesWhy is income under absorption costing affected by the production level when that for variable costing is not? The answer lies in the different treatment of fixed overhead costs for the two methods. Under absorption costing, fixed overhead per unit is lower when 100,000 units are produced than when 60,000 units are produced, and then fixed overhead cost is allocated to more unitsrecall Exhibit 6.8. If those excess units produced are not sold, the fixed overhead cost allocated to those units is not expensed until a future period when those units are sold.Reported income under variable costing, on the other hand, is not affected by production level changes because all fixed production costs are expensed in the year when incurred. Under variable costing, companies increase reported income by selling more unitsit is not possible to increase income just by producing more units and creating excess inventory.

Over the long run, price must be high enough to cover all costs, including variable costs and fixed costs, and still provide an acceptable return to shareholders. For this purpose, absorption cost information is useful because it reflects the full costs that sales must exceed for the company to be profitable.Lets go back to Ice Age to see how we can use our knowledge of variable costing in a special order decision. To illustrate, lets return to the data of Ice Age Company and examine Exhibit 6.11. Recall that its variable production cost per unit is $15 and its total production cost per unit is $25 (at production level of 60,000 units). Assume that it receives a special order for 1,000 pairs of skates at an offer price of $22 per pair from a foreign skating school. This special order will not affect Ice Ages regular sales and its plant has excess capacity to fill the order.Drawing on absorption costing information, we observe that cost is $25 per unit and that the special order price is $22 per unit. These data would suggest that management would reject the order as it would lose $3,000, computed as 1,000 units at $3 loss per pair ($22-$25).However, closer analysis suggests that this order should be accepted. This is because the $22 order price exceeds the $15 variable cost of the product. Specifically, Exhibit 6.11 reveals that the incremental revenue from accepting the order is $22,000 (1,000 units at $22 per unit) whereas the incremental production cost of the order is $15,000 (1,000 units at $15 per unit) and the incremental variable selling and administrative cost is $2,000 (1,000 units at $2 per unit). Thus, both its contribution margin and net income would increase by $5,000 from accepting the order. We see that variable costing reveals this opportunity while absorption costing obscures it. The reason for increased income from accepting the special order lies in the different behavior of variable and fixed production costs. We see that if the order is rejected, only variable costs are saved. Fixed costs, on the other hand, do not change in the short run regardless of rejecting or accepting this order. Since incremental revenue from the order exceeds incremental costs (only variable cost in this case), accepting the special order increases company income.Contribution margin income statements prepared under variable costing are useful in performing cost-volume-profit analyses. Managers often prepare contribution margin reports, like the one shown, which exclude fixed expenses, to convey contribution margins to aid in business decisions.

This type of report can aid in various what if scenarios. Fro example, if we multiply the contribution margin ratio by an expected change in sales, we get the expected change in contribution margin for that sales change. To illustrate, if Precision Tech expects sales to increase by $2,000 next year, it can expect to see contribution margin increase by $844 ($2,000 x 0.422). One important generally accepted accounting principle is that of matching. Most managers interpret the matching principle as expensing all manufacturing costs, both variable and fixed, in the period when the related product is sold rather than when incurred. Consequently, absorption costing is almost exclusively used for external reporting. For income tax purposes, absorption costing is the only acceptable basis for filings with the Internal Revenue Service (IRS) under the Tax Reform Act of 1986.Thus, and despite the many useful applications and insights provided by variable cost reports, absorption costing is the only acceptable basis for both external reporting and tax reporting. Also, as we discussed, top executives are often awarded bonuses based on income computed using absorption costing. These realities contribute to the widespread use of absorption costing by companies.Given the advantages of both variable costing and absorption costing, we need to apply and understand both methods. For example, companies commonly use variable costing for internal reporting and business decisions, and use absorption costing for external reporting and tax reporting. For companies concerned about the cost of maintaining two costing systems, it is comforting to know that we can readily convert reports under variable costing to that using absorption costing.To illustrate, lets again refer to Ice Ages data for the three years 2007 through 2009 in Exhibit 6.15Specifically, in 2008, absorption costing income was $200,000 higher than variable costing income. The $200,000 difference was because the fixed overhead cost incurred in 2008 was allocated to the 20,000 units of ending inventory under absorption costing (and not expensed in 2008 under absorption costing). On the other hand, the $200,000 fixed overhead costs (along with all other fixed costs) were expensed in 2008 under variable costing.Exhibit 6.15 shows the computations for restating income under the two costing methods. To restate variable costing income to absorption costing income for 2008, we must add back the fixed overhead cost deferred in ending inventory. Similarly, to restate variable costing income to absorption costing income for 2009, we must deduct the fixed overhead cost recognized from beginning inventory, which was incurred in 2008, but expensed in the 2009 cost of goods sold when the inventory was sold.Review the break even formula. See if you can calculate the proper break even point.This finding implies that the company must produce and sell 34,783 units to break-even (zero income). Sales less than that amount would yield a net loss and sales above that amount would yield net income.

Now that we have mastered some of the basic concepts and principles of managerial accounting as it relates to variable costing and performance reporting, we are ready to put this knowledge to work.

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Chap 006 - 2e by Wild and Shaw